Political Risk

Portfolio Investment

• Sovereign debt– Default risk premium (likelihood of default)– Financial crisis (banking, liquidity, currency)

• Cannot borrow at all

• Market decides that the country is insolvent– PV(FS) > NA + PV (FR)

• Spillover to other financial investments

Foreign Direct Investment

• Political exposure: the degree to which a company’s value is threatened by political events – America’s presidential or congressional elections

• Political risk: the variability in the value of the business (or a subsidiary) that is caused by uncertainty about political or policy changes

Nature of political risk

Host country policy

Taxation Expropriation and nationalization Foreign exchange control

Price control

Forces JV

Equity dilution

Nature of political risk

Home country policy

Required divestment

SanctionsLicensing

requirements

Change in tax treatment of foreign

income (the tax holiday)

Transfer prices

Effect of home-country and third-country policies

• Home country policies: MNC home country’s policies that restrict trade and investment activities

• Often overlooked but very important in formulating a corporate strategy to deal with political risk

• US embargo against Cuba

• Tend to have technology restrictions to protect national security

• US defense firms probably shouldn’t be able to sell nuclear technology to Iran (they aren’t)

Reasons for FDI policies

• Often driven by foreign policy– Some Arab nations prohibit trade between themselves and

Israel

• Want to protect domestic industry – Protectionist policies to protect constituents

• Taxation has a large role as part FDI policies– Aaron’s presentation – Companies seek out countries with the lowest tax rate – Countries with a lot of foreign trade/direct investment

may find it necessary to lower tax rates to increase tax revenues

Political Risk Assessment (home country)

• Trade climates

• Investment attitudes

• Potential for embargos

• Forced divestments

Multilateral Policies

• UNCTC: United Nations Center on Transnational Corporation

• OECD: Organization for Economic cooperation and Development

• WTO: World Trade Organization • EU: European Union

– Serve as checklists for mutual privileges and responsibilities

Political Risk Assessment (host

country) • The “macro approach”

– Aggregation of subjective assessments by a panel of experts on various economic, social, and political factors

• Global Research Center

• Political Risk Yearbook (Political Risk Services of East Syracuse, New York)

• International Country Guide

• The Economist Intelligence Unit – Provides quarterly ratings and individual report on each country

Host country continuumFriendliness to FDI

Complete prohibition

Many incentives

North Korea Ireland and Singapore

India U.S

General vs. Selective

• General policy changes: not directed at FDI– Any change in tax code or government policies can

effect everyone

• Selective policy changes: directed mainly at FDI – Usually industry specific

– Most costly kind of government policy • Drives away FDI

– Less tax revenue for government

– May reduce total investment

Political Risk Assessment (host country)Aggregate Summary Average

Overall Risk

Avg Pol

Avg Eco

Avg Leg

Avg Tax

Avg Ope

Avg Sec

All Countries 2.76 2.76 2.87 2.62 2.5 2.88 2.63

Asia-Pacific 2.82 2.76 3.06 2.48 2.62 3.08 2.53

CIS 3.4 3.44 3.44 3.46 3.06 3.52 3.4

Europe 1.93 1.91 1.97 1.76 1.83 2.04 1.91

Latin America and Caribbean 2.55 2.55 2.8 2.38 2.05 2.59 2.4

Middle East and North Africa 2.93 2.9 2.77 3.04 2.69 3.1 3.07

North America 1.46 1.5 1.5 1 1 1.5 2

Sub-Saharan Africa 3.37 3.43 3.45 3.3 3.19 3.44 3.14

Political Risk Assessment (micro approach)

• Micro approach: industry-specific and business specific factors – Political risk depends directly on the

characteristic of foreign investment • Who owns it?

• What technology does it use?

• What is its economic sector?

Political Risk Assessment (take away)

It can be diversified away– High risk (variance) is usually associated with high

(mean) returns. – Most of the variance in returns to investment is driven

by local and global economic conditions. – Global economic conditions account for the portion of

risk you cannot diversify away (the covariant portion of your cash flows from investments in various parts of the world). Political risk is local and residual (not correlated with global economic conditions). Therefore, you ought to be able to diversify it away.

Managing Political Risk (ex ante)

• OPIC: Overseas Private Investment Corporation– 50% of business must be own by US citizens– Foreign corporation: 95% must be owned by US entity

• Subsidiary

• MIGA: World Bank Multilateral Investment Guarantee Agency – Incorporation in member nation – Majority own by citizens of member nation

• 97 countries have signed MIGA convention, 71 have ratified – Ratification is required to participate – Host country need to also be a member of MIGA

• Lloyds of London private insurance business

Types of Coverage

• Expropriation: protects against partial or total loss of investment as result of governmental actions – Losses are assessed based on book value

• Currency inconvertibility: protection against losses arising from an investor’s inability to convert local currency into the foreign currency specified in the policy – Devaluation is not covered– Date of loss is considered to be the date when the request

for funds transfer is denied, not on the expiration date of the stated waiting period

Types of Coverage con’t

• War and civil disturbance: protects against losses resulting from damage, destruction or disappearance of assets as the result of acts of war or civil disturbance– Covers: revolution, insurrection, golpes de estado,

sabotage, and terrorism

– In case of war firms do not have to loss property to file a claim, they do have to show interruption to business

– Losses are assessed at book value

• Breach of contract: protects against a host country’s breach or repudiation of the investor’s contract – Covers losses on project investments not loss of profits

Private vs. Government Insurance

Private• No host country nationality

requirements • Will insure new and existing

projects • Shorter terms (3 year basis--

renewable) • More flexibility and opportunity

to negotiate policy provisions• Non-disclosure provision• Harder to collect on your claim

Government• Usually requires “home” country

citizenship• Only insure new projects and

expansion to existing ones • Longer terms (15-20 years) • Usually cheaper than private

insurance • Less flexibility in policy

provisions • Full disclosure to host

government • Easier to collect on claim

De Facto Political Risk Insurance

• Joint venture

• Borrow from a local bank

• Get a multilateral institutions to be an investor – World bank or Inter-American Development

Bank

Managing Political Incidents (ex post)

• Follow the law and alter operations accordingly – business with low bargaining power usually have no

choice but to do so

• Discontinue operations – The law may hurt your operations to such an extent that

following the law is not acceptable (IBM)

• Negotiate a settlement – business can use threat to discontinue operations to

negotiate favorable treatment, but only if the country stands to lose if the business leaves

Benefits and costs of hostility toward FDI

Benefits• Expropriation: business’s

assets• Currency controls: more

macroeconomic control• More regulation:

microeconomic control over affected industry

• Tax: increase in tax revenue

Cost• Expropriation: less FDI

decline in economic base, higher unemployment, and less technology transfer

• Macroeconomic controls: general stagnation

• Tax: reduction in tax revenues because firms will begin to shop for more favorable tax rates